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Monday, April 05, 2010

Incomes, outgoings and outcomes

Following on from my post regarding "free trade", I now want to explain why this matters to the economy.

I suspect most of the people who read this blog have a job - or have had one in the past - and know what it is like to manage their finances. A job brings income and this is your "wealth" - but living also has costs attached to it and these costs represents your outflow of wealth. Eventually you reach a balance between the two which becomes your "living standard".

With any luck you can reach a point where your increase in income growth is faster than the increase in expenses growth - and when you reach that you have improving living standards.

But if you reach a point where the rise in your income is less than the rate at which money is leaving your household then you will be forced to cut back and this will represent a drop in living your living standard.

We all know this. It's why we want and negotiate pay rises every year - not just to give us more money, but to cover the increased costs we are having to face through inflation. If the rate at which our pay increases is less than the rate of inflation we all know that we are worse off in real terms.

It's the same for a national economy. We have an income and expenses. However, for a national economy the income comes from GDP rather than wages and the expenses - the outflow of wealth from the national economy - is the trade deficit.

The trade deficit represents the flow of money out of the "household" and is equivalent to internal inflation. It is currently running at around 5% of GDP per year - but, more than this, our trade deficit has been consistently higher than our GDP growth for decades.

We all know that if we receive a 2% pay increase while inflation is running at 5% then that represents a 3% drop in our wealth in real terms. We are faced with a choice - increase our income or decrease our costs. Few of us can increase our income arbitrarily, so most of us choose to cut costs - and this invariably means lower living standards.

Over the last decade or so we have all experienced this in some way. For many of us we have been able to cushion this by increasing our debt - but we also know that this is ultimately unsustainable. The debt has to be repaid at some point and the only way to do this is to either increase your income substantially or face significant cuts in your living standards.

How we do this is up to us. It might mean cutting back on nights out or cancelling the Sky subscription or cutting back on the groceries - but whatever it is it will mean a reduction in living standards.

It's exactly the same for a national economy - except on a bigger scale. I know people will argue that it isn't as simple as I have suggested here, but in essence it is. Increasing our national income by growing GDP is only beneficial if it is more than the rate at which the money is flowing out of our country through the trade deficit.

Over the last 30 years we've not been doing this - instead we've been storing up debt. There are only two ways out of this. Either we reduce the outflow of money from our economy by getting the trade deficit below the level of GDP growth or we face up to the fact that we are going to have to suffer substantial cuts to the services and benefits that our national economy can afford.

We know this is true because we all deal with it day after day - but for some reason we ignore the obvious when it comes to the national economy. Trade is income - and when the money coming is rising slower than the money going out you know you're going to struggle.

Debt can not be the solution forever. You all know that if nothing is done about it then the outcome is going to bankruptcy.